FINANCIAL MANAGEMENT

Section4

I. SummaryWorkingCapitalManagement WorkingcapitalmanagementisconcernedwiththeproblemsthatariseinmanagingtheCurrentassets( CA),currentliabilities(CL)andtheinterrelationshipsbetweenthem.ItsOperationalgoalistomanagethe CA&CLinsuchawaythatasatisfactory/acceptablelevelofnetworkingcapital(NWC)ismaintained. Therearetwoconceptsofworkingcapital(WC):grossandnet.ThegrossWCmeansthetotalCAandCL TheNWCisnecessaryduetononsynchronousnatureofexpectedcashinflowandrequiredcashoutflow. Themorepredictablethecashinflowsare,thelessNWCwillberequiredandviceversa.TheNWC representtheliquiditypositionofafirm. TheNWChasabearingonliquidity,profitabilityandriskofbecomingtechnicallyinsolventingeneral,the greateristheNWC,thehigheristheliquidity,theloweristheriskandtheProfitability,andviceversa. ThetradeoffinbetweenprofitabilityandriskisanimportantElementintheevaluationofthelevelof NWCofafirm. Theneedofworkingcapital(WC)arisesfromthecash/operationcycleofafirm.ItreferstoThelengthof timerequiredtocompletethefollowingthesequenceofevents:conversionofCashintoinventory, inventoryintoreceivablesandreceivablesintocash.TheopeningcycleCreatestheneedforworking capitalanditslengthintermstimespanrequiredtocompletethecycleisthemajordeterminantofthe firmsworkingcapitalneeds.

II. SummaryofCashManagement Cashisthereadycurrencytowhichallliquidassetscanbereduced. Nearcashimpliesmarketablesecuritiesviewedthesamewayascashbecauseoftheirhighliquidity. Marketablesecuritiesareshortterminterestearningmoneymarketinstrumentsusedbyfirmstoobtaina returnontemporaryidlefunds. Motivesforholdingcash Transactionmotiveisforholdingcash/nearcashtomeetroutinecashrequirementstofinance transactioninthenormalcourseofbusiness. Precautionarymotiveismotiveforholdingcash/nearcashascushiontomeetunexpected contingencies/demandforcash. Speculativemotiveismotiveforholdingcash/nearcashtoquicklytakeadvantageofopportunities typicallyoutsidethenormalcourseofbusiness. Compensatingmotiveisamotiveforholdingcashtocompensatebanksforprovidingcertainservicesor loans. Thebasicobjectivesofcashmanagementaretwofold:(a)tomeetthecashdisbursementneeds(payment schedule),and(b)tominimizefundscommittedtocashbalances.Theseareconflictingandmutually contradictoryandthetaskofcashmanagementistoreconcile.

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FINANCIAL MANAGEMENT

Section4

MeetingPaymentSchedule:inthenormalcourseofbusiness,firmshavetomakepaymentsofcashona continuousandregularbasistosuppliersofgoods,employeesandsoon.Atthesametime,thereisa constantinflowofcashthroughcollectionsfromdebtors. MinimizingFundsCommittedtoCashBalances:Thesecondobjectiveofcashmanagementistominimize cashbalances.Inminimizingthecashbalances,twoconflictingaspectshavetobereconciled.Ahighlevel ofcashbalanceswill,asshownabove,ensurepromptpaymenttogetherwithalltheadvantages.Butitis alsoimpliesthatlargefundswillremainidle,ascashnonearningassetandthefirmwillhavetoforego profits.Alowlevelcashbalances,ontheotherhand,maymeanfailuretomeetthepaymentschedule. Theaimofcashmanagement,therefore,shouldbetohaveanoptimalamountofcashbalances. III. SummaryofReceivablesManagement Thetermreceivablesisdefinedasdebtownedtothefirmbycustomersarisingfromsaleofgoodsand servicesintheeordinarycourseofbusiness.Whenafirmmakesanordinarysaleofgoodsorservices anddoesnotreceivepayment,thefirmgrantstradecreditandcreatesaccountsreceivableswhichcould collectedinthefuture.Receivablesmanagementisalsocalledtradecreditmanagement.Thus,accounts receivablerepresentanextensionofcredittocustomers,allowingthemareasonableperiodoftimein whichtoforthegoodsreceived. Costsassociatedwiththeextensionofcreditandaccountsreceivableare: Collectioncostistheadministrativecostincurredincollectingreceivables. Capitalcostisthecostoftheuseofadditionalcapitaltosupportcreditsaleswhichalternativelycould havebeenemployedelsewhere. Delinquencycost:arisingoutoffailureofcustomerstopayonduedate. Defaultcost:aretheoverduesthatcannotberecovered. Creditpolicyisthedeterminationofcreditstandardsandcreditanalysis IV. SummaryofInventoryManagement Thebasicresponsibilityofthefinancialmanageristomakesurethefirmscashflowsaremanaged efficiently.Efficientmanagementofinventoryshouldultimatelyresultinthemaximizationoftheowners wealth.Itimpliesthatwhilethemanagementshouldtrytopursuethefinancialobjectiveofturning inventoryasquicklyaspossible,itshouldatthesametimeensuresufficientinventoriestosatisfythe productionandsalesdemands. Orderingcost:isthefixedcostofplacingandreceivinganinventoryorder. Carryingcosts:Thesecondboardcategoryofcostsassociatedwithinventoryarethecarryingcosts.They areinvolvedinmaintainingorcarryinginventory.Thecostofholdinginventorymaybedividedintotwo categories: 1.Thosethatariseduetothestoringofinventory.Themaincomponentsofthiscategoryofcarryingcosts are(i)storagecost,thatis,tax,depreciation,insurance,maintenanceofthebuilding,utilitiesandjanitorial

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FINANCIAL MANAGEMENT

Section4

services;(ii)insuranceofinventoryagainstandtheft;(iii)deteriorationininventorybecauseofpilferage, fire,technicalobsolescence,styleobsolescenceandpricedecline;(iv)servingcosts,suchaslaborfor handlinginventory,clericalandaccountingcosts. TheOpportunityCostFunds:Thisconsistsofexpensesinraisingfunds(interestoncapital)tofinancethe acquisitionofinventory.Iffundswerenotlockedup;ininventory,theywouldhave Earnedareturn.Thisistheopportunitycostoffinancialcostcomponentofthecost.Thecarryingcosts andtheinventorysizearepositivelyrelatedandmoreinthesamedirection.ifthelevelofinventory increases,thecarryingcostsalsoincreaseandviseversa.Thesumoftheorderandcarryingcosts representsandtotalcostofinventory.thisiscomparedwiththebenefitsarisingoutofinventoryto determinetheoptimumlevelofinventory. Leadtime:istimenormallytakeninreceivingdeliveryafterplacingorderswithsuppliers. Safetystocks:impliesextrainventoriesthatcanbedrawndownwhenactualleadtimeand/orusagerates aregreaterthanexpected.

V. SummaryofLeverage Leverage:istheemploymentofanasset/sourceoffinanceforwhichfirmpaysfixedcost/fixedreturn. Leveragereferstotheuseofanassetorsourceoffundswhichinvolvesfixedcostsorfixedreturns.Asa result,theearningsavailabletotheshareholders/ownersareaffectedasalsotheirrisks.Therearethree typesofleverage,namely,operating,financialandcombined. Leverageassociatedwithassetacquisitionorinvestmentactivitiesisreferredtoastheoperatingleverage. Itrefertothefirmsabilitytousefixedoperatingcoststomagnifytheeffectofchangesinsalesonits operatingprofits(EBIT)andresultsinmorethanaproportionatechange(+/)inEBITwithchangeinthe salesrevenue. Degreeinoperationalleverage(DOL)iscomputedintwoways:(i)PercentagechangeinEBIT/Percentage changeinsalesand(ii)(SalesVariablecosts)/EBITorContribution/EBIT Theoperatingleverageisfavorablewhenincreaseinsalesvolumehasapositivemagnifyingeffecton EBIT.ItisunfavorablewhendecreaseinsalesvolumehasanegativemagnifyingeffectonEBIT.Therefore, highDOLisgoodwhensalesrevenuesarerisingandbadwhentheyarefalling. TheDOLismeasureofthebusiness/operatingriskofthefirm.Operatingriskistheriskofthefirmnot beingabletocoveritsfixedoperatingcosts.Thelargeristhemagnitudeofsuchcost,thelargeristhe volumeofsalesrequiredtorecoverthem.Thus,theDOL,dependsonfixedoperatingcosts. Financialleverageisrelatedtothefinancingactivitiesofafirm.Itresultsfromthepresenceoffixed financialcharges(suchasinterestondebtsanddividendonpreferenceshares).Sincesuchfinancial expensesdonotvarywiththeoperatingprofits,financialleverageisconcernedwiththeeffectofchanges inEBITontheearningsavailabletoequityholders.Itisdefinedastheabilityofafirmtousefixedfinancial chargestomagnifytheeffectofchangesinEBITontheearningspershare(EPS). Thedegreeoffinancialleverage(DFL)canbecomputedinthefollowingways: (i) DFL=PercentagechangeinEPS/PercentagechangeEBIT.

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FINANCIAL MANAGEMENT (ii) (iii) DFL=EBIT/(EBITI),whendebtisused. DFL=EBIT/(EBITIDp/(1t)),whendebtaswellaspreferencecapitalisused.

Section4

Financialleverageinvolvestheuseoffundsobtainedatafixedcostinthehopeofincreasingthereturnto theequityholders.Whenafirmearnsmoreontheassetspurchasedwiththefundsthanthefixedcostof theiruse,thefinancialleverageisfavorable.Unfavorableleverageoccurswhenthefirmdoesnotearnas muchasfundscost. Highfixedfinancialcostsincreasethefinancialleverageand,thus,financialrisk.Thefinancialriskrefersto theriskofthefirmnotbeingabletocoveritsfixedfinancialcosts.Incaseofdefault,thefirmcanbe technicallyforcedintoliquidation.Thelargeristheamountoffixedfinancialcosts,thelargerisEBIT requiredtorecoverthem.Thus,theDFLdependsonfixedfinancialcosts. Todeviseanappropriatecapitalstructure,theamountofEBITundervariousfinancingplansshouldbe relatedtoEPS.TheEBITEPSanalysisEPSisawidelyusedmethodofexaminingtheeffectoffinancial leverage/useofdebt.AfinancialalternativethatensuresthelargestEPSispreferred,giventhelevelof EBIT. Financialbreakevenspoint(BEP)representsapointatwhichbeforetaxearningsareequaltothefirms fixedfinancialobligations.Symbolically,iscomputedasfollows:(I+Dp+Dt)/(1t)).Inotherwords,at financialBEP,EPSiszero. TheEBITlevelatwhichtheEPSisthesamefortwoalternativefinancialplansisknownastheindifference point/level.BeyondtheindifferencelevelofEBIT,thebenefitsoffinancialleveragebegintooperatewith respecttoEPS. Combinedleverage(DCL)istheproductofoperatingandfinancialleverage.Itindicatestheeffectthat changesinsaleswillhaveonEPS.Symbolically,itcanbecomputedbythefollowingmethods: (i) DCL=DOLXDFL (ii) DCL=PERCENTAGECHANGEINEPS/PERCENTAGECHANGEINSALES (iii) DCL=(SALERSVARIABLECOSTS)/(EBIT1) Combinedleverageisameasureofthetotalriskofthefirm.Tokeeptheriskwithinmanageablelimits,a firmwhichhashighdegreeofoperatingleverageshouldhavelowfinancialleverageandviceversa. EBITEPSanalysis/approachisanapproachforselectingcapitalstructurethatmaximizesearningpershare (EPS)overtheexpectedrangeofearningsbeforeinterestandtaxes.

VI. SummaryofCapitalStructureTheories Capitalstructurerefertothemixorproportionofdifferentsourcesoffinance(debtandequity)tototal capitalization.Afirmshouldselectsuchafinancingmixwhichmaximizesitsvalue/theshareholders wealth(orminimizesitsoverallcostofcapital).Suchacapitalstructureisreferredtoastheoptimum capitalstructure. Capitalstructuretheoriesexplainthetheoreticalrelationshipbetweencapitalstructure,overallcostof capitalandvaluation.Thefourimportanttheoriesare:(i)Netincome(NI)approachand(ii)Netoperating income(NOI)approach,(iii)ModiglianiandMiller(MM)approachand

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FINANCIAL MANAGEMENT ASSUMPTIONS

Section4

1. Thereareonlytwosourcesoffundsusedbyafirm:perpetualdebtandordinaryshares. 2. Therearenocorporatetaxes.Thisassumptionisremovedlater. 3. Thedividend/payoutratiois100%.Thatistotalearningsarepaidoutasdividendtotheshareholders andtherearenoretainedearnings. 4. Thetotalassetsaregivenanddonotchange.Theinvestmentdecisionsare,inotherwords,assumed tobeconstant. 5. The total financing remains constant. The firm can change its degree of leverage (capital structure) either by selling shares and use the proceeds to retire debentures or by raising more debts and reducetheequitycapital. 6. Theoperatingprofits(EBIT)arenotexpectedtogrow. 7. All inventories are assumed to have the same subjective probability distribution of the future expectedEBITforagivenfirm. 8. Businessriskisconstantovertimeandisassumedtobeindependentofitscapitalstructure. 9. Perpetuallifeofthefirm. DefinitionsANDSYMBOLS: In addition to the above assumptions, we shall make use of some symbols in our analysis of capital structuretheories: S=totalmarketvalueofequity B=totalmarketvalueofdebt I=totalinterestpayments V=totalmarketvalueofthefirm(V=S+B) S=(EBITI)/KeorEBT/Ke

Netincome(NI)approach Netoperatingincome(NOI)approach TheNOIapproachisdiametricallyoppositetotheNIapproach.Theessenceofthisapproachisthecapital structuredecisionofacorporatedoesnoteffectitscostofcapitalandvaluation,andhence,irrelevant. AccordingtotheNIapproach,capitalstructureisrelevantasitsaffectsthecostofcapitalandvaluationof thefirm. Thecoreofthisapproachisthatastheratiooflessexpensivesourceoffunds(i.e.,debt)increasesinthe capitalstructure,thecostofcapital(ko)decreasesandvaluation(V)ofthefirmincreases. Withajudiciousmixtureofdebtandequity,afirmcanevolveanoptimumcapitalstructureandwhichthe (ko)wouldbethelowest,thevofthefirmthehighestandmarketpricepersharethemaximum.

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FINANCIAL MANAGEMENT

Section4

ThemainargumentofNOIisthatandincreaseintheproportionofdebtinthecapitalstructurewould leadtoanincreaseinthefinancialriskoftheequityholders.Tocompensatefortheincreasedrisk,they wouldrequireahigherrateofreturn(ke)ontheirinvestment.Asaresult,theadvantageofthelowercost ofdebtwouldexactlybeneutralizedbytheincreaseinthecostofequity.Thecostofdebthastwo components:(i)explicit,representedbyrateofinterest,and(ii)implicit,representedbytheincreasedin thecostofequitycapital.Therefore,therealcostofdebtandequitywouldbethesameandthereis nothinglikeanoptimumcapitalstructure. AsperNOI,V=EBIT/Ko S=VB

ModiglianiandMillerApproach ModiglianiandMiller(MM)concurwithNOIandprovideabehavioraljustificationfortheirrelevanceof capitalstructure. Theymaintainthatthecostofcapitalandvalueofthefirmdonotchangewithachangeofleverage.They contendthatthetotalvalueofhomogeneousfirmsthatdifferonlyinrespectofleveragecannotbe differentbecauseoftheoperationsofarbitrage. Thearbitragerefertotheswitchingoveroperations,thatis,theinvestorsswitchoverfromovervalued firm(leveredfirm)totheundervaluedfirms(unlevered).Theessenceofarbitrageisthattheinvestors (arbitragers)areabletosubstitutepersonalorhomemadeleverageforcorporateleverage.Theswitching operationdrivesthetotalvalueofthetwohomogeneousfirmsequal. Thebasicpremisesof(MM)approach,inpractice,areofdoubtfulvalidity.Asaresult,thearbitrage processisimpeded.Totheextent,thearbitrageprocessisimperfect,itimpliesthatthecapitalstructure matters. TheMMcontendthatwithcorporatetaxes,debthasadefiniteadvantageasinterestpaidondebtistax deductibleandleveragewilllowertheoverallcostofcapital.Thevalueoftheleveredfirm(V1)would exceedthevalueoftheunleveredfirm(Vu)byanamountequaltoleveredfirmsdebtmultipliedbytax rate.

FactorsimpactingCapitalStructureDecision Ahostoffactors,bothquantitativeandqualitativeincludingsubjectivejudgmentoffinancialmanagers, haveabearingofthedeterminationofanoptionalcapitalstructureofafirm.Theyarenotonlyhighly complexbutalsoconflictinginnatureand,therefore,cannotfitentirelyintoatheoreticalframework. Moreovertheweightsassignedtovariousfactorsalsovarywidelyaccordingtoconditionsintheeconomy, theindustryandthecompanyitself.Therefore,acorporateshouldattempttoevolveanappropriate capitalstructure,giventhefactsoftheparticularcase. Thekeyfactorsrelevanttodesigninganappropriatecapitalstructureare,(i)profitability,(ii)liquidity,(iii) control,(iv)leverageratiosinindustry,(v)natureofindustry,(vi)consultationwithinvestment banks/lenders,(vii)commercialstrategy,(viii)timing,(ix)companycharacteristicsand(x)taxplanning. PROFITABILITYASPECT:Keepinginviewtheprimaryobjectiveoffinancialmanagementofmaximizingthe market value of the firm, the EBITEPS analysis should be considered logically by the first step in the

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FINANCIAL MANAGEMENT

Section4

directionofdesigningafirmscapitalstructure.Giventheobjectiveoffinancialmanagementtomaximize the share holders wealth, a corporate should carryout profitability analysis in terms of determining the amount of EBIT Indifference point at which its MPS is identical under two proposed financial plans. In general, the higher the level of EBIT than the indifference point and the lower the probability of its downwardfluctuation,thegreateristheamountdebtthatcanbeemployedbyacorporate. LIQUIDITYASPECT:EBITEPSanalysisandcoverageratiosareveryusefulinmakingexplicittheimpactof leverageonEPSandonthefirmsabilitytomeetitscommitmentsatvariouslevelsofEBIT.ButtheEBIT/ interestratioislessthanaperfectmeasuretoanalysethefirmsabilitytoservicefixedchargesbecause thefirmsabilitytodosodependsonthetotalpaymentsrequired,thatis,interestandprincipal,inrelation tothecashflowavailabletometthem.Therefore,theanalysisofthecashflowabilityofthefirmtothe servicefixedchargesisanimportantexercisetobecarriedoutincapitalstructureplanninginadditionto profitabilityanalysis. CoverageratiocanalsobeusedtojudgetheadequacyofEBITtomeetthefirmsobligationstopay financialcharges,interestonloan,preferencedividendandrepaymentofprincipal.Ahigherratioimplies thatthefirmcangoforlargerproportionsofdebtinitcapitalstructure. Anothermajortodeterminetheadequacyofcashflowtomeetthefixedobligationsincashbudget.A cashbudgetshouldbepreparedforarangeofpossiblecashinflowswithaprobabilityattachedtoeachof them.Sincetheprobabilityofvariouscashflowpatternisknown,thefirmcandeterminethelevelofdebt itcanemployandstillremainwithinaninsolvencylimittolerabletothemanagement.Theimpactof alternativedebtpoliciesshouldalsobeexaminedunderadversecircumstances/recessionconditions.To retaincontrolovermanagement,afirmwouldpreferuseofdebttoequity.Adebtequityratiooffirm shouldbesimilartothoseofothercompaniesintheindustry.Incasesalesaresubjecttowide fluctuations,afirmshouldemploylessdebt.Firmsubjecttokeencompetitionshouldpreferagreater proportionofequity.Thecorporateinindustrygroupswhichareattheirinfancyshouldrelymoreon equitycapital.Investmentanalysts/bankers/institutionalinvestorsunderstandthecapitalmarketbetter aswellasrequirementsofinvestors/lenders.Theiropinionisalsousefulindesigningcapitalstructure. Anappropriatecapitalstructureshouldprovideroomforflexibilitynotinobtainingfundsbutalsoin refundingthem. Publicissuesofshareaswellasdebtcapitalshouldbemadeattimewhenthestateofeconomyaswellas capitalmarketisidletoprovidethefunds.Forinstance,itwillbeusefultopostponeborrowingsifdecline ininterestratesisexpectedinthefuture. Thecharacteristicsforcompany,interalia,intermsofsizeincreditstandingaredecisiveindeterminingin itscapitalstructure.Whilelargefirmsenjoyingthehighcreditstandingamonginvestorsareinabetter positiontoobtainfundsfromthesourcesoftheirchoice,therelativelysmallfirms,newfirmsandfirms havingpoorcreditstandinghavelimitedoptioninthisregard. Thechoiceofandappropriatedebtpolicyinvolvestradeoffbetweentaxbenefitsandcostoffinancial distress.Moreover,themanagementshouldconsidertheimplicitcostofthetaxsubsidyinusingdebt. VII. BetaEstimation

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FINANCIAL MANAGEMENT

Section4

Beta()ofastockorportfolioisanumberdescribingtherelationofitsreturnswiththatofthefinancial marketasawhole Betaisalsoreferredtoassystematicrisk.Theriskinherenttotheentiremarketorentiremarketsegment. Alsoknownas"undiversifiablerisk" AnassethasaBetaofzeroifitsreturnschangeindependentlyofchangesinthemarket'sreturns.A positivebetameansthattheasset'sreturnsgenerallyfollowthemarket'sreturns,inthesensethatthey bothtendtobeabovetheirrespectiveaveragestogether,orbothtendtobebelowtheirrespective averagestogether.Anegativebetameansthattheasset'sreturnsgenerallymoveoppositethemarket's returns:onewilltendtobeaboveitsaveragewhentheotherisbelowitsaverage.[ Inotherwords,betagreaterthan1meansthatreturnofasecurityaremorevolatileascomparedtothe marketreturns.Ifthebetaislessthan1thenitmeansthatreturnofasecurityarelessvolatileas comparedtothemarketreturns Formulaforcalculatingbeta = NXMXM NM2(M)2

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